Sources of Capital: Royalty Financing and Micro-Cap Public Entities

Royalty financing is an advance against future product or service sales. The advance is repaid by diverting a percentage of the product or service revenues to the investor who issued the advance. This approach to financing works for established companies that have a product or service, or emerging companies about to launch a product with high gross and net margins.1 Traditional uses of royalty financing are for businesses in mining, energy, and life science markets. However, we have found some applications for technology companies.

Royalty financing may be applicable to companies involved in life sciences, such as specialty pharmaceuticals and biotechnology firms. These companies may gain considerable advantage by selling current royalty entitlements or future royalties to create nondilutive sources of capital. Some royalty finance companies will purchase all or part of a company's entitlement and may structure transactions to include upside participation via sales thresholds to minimize the cost of capital. In some instances, the royalty financing may be structured with a fixed monthly principal payment and royalty payments that return a multiple of the initial investment, plus stock warrants.2

Technology Example #1-A Software Company

This example is from Peter Moore, founder of Banking Dynamics, a consulting firm in Portland, Maine.3

Moore structured a financing to help a software company grow its sales. He approached the Greater Portland Building Fund and Coastal Enterprises Inc., quasi-public economic development organizations charged with developing business in the state. He sought an advance of $200,000 against its future sales. If the advance was made, each investor would get 3 percent of the software company's sales for 10 years, or until they received payments totaling $600,000. This $600,000 would represent the original $200,000 investment plus $400,000. For the investors to receive the agreed-upon $600,000 within the maximum allowable time frame, the software company would have to generate total sales of $20 million over 10 years. Although the software company had less than $1 million in sales at the time, it had over the course of its three-year life doubled sales each year. "This was a big selling point," Moore says. Moreover, investors were comforted by the fact that the firm's software program, which helps companies manage hazardous-waste streams, meant there were 300,000 potential customers, he points out.

The transaction was structured so that the time frame was flexible-up to 10 years to make repayment; however the return, $600,000, was not. Because of this, the return the investors could earn was variable as well, and ranged from marginal to exceptional. Specifically, if the software company repaid the advance in 10 years, the investors would earn a compound annual return of 11.6 percent on their investment. If, however, the company's sales mushroomed and $600,000 was paid to the investors in five years, their compound annual return also mushroomed to 24.5 percent.

It took Moore and his client about four months to negotiate the deal. One of the key terms was for a delay in the commencement of royalty payments. Specifically, royalties did not accrue until 90 days after the deal closed. In addition, the actual royalty payments did not have to be paid until 60 days after the revenues were recognized. "All in all, it was five months from the time the company received the financing until the first payment was due," Moore says. "This gave the owners the time they needed to put the capital to work and start producing sales."

This example is atypical because the investors were willing to take a below-market return for an early stage deal with an unproven market record. This illustrates that angel investing is as varied as the personalities and experience of the individual investors. Typically, more sophisticated investors would have required some form of equity participation in the form of warrants, preferred stock, or common stock.

Technology Example #2-Applied Intelligent Systems

In another example,4 Jim Anderson didn't have the luxury of mulling over a range of options when he was looking for capital for Applied Intelligent Systems Inc. (AISI), a $4 million maker of machine vision systems in Ann Arbor, Michigan. Once the darling of venture capitalists, his industry had become poison to investors after dozens of machine vision companies performed poorly or failed altogether. AISI had been able to obtain several infusions of venture capital, but by the time Anderson went hunting for money to launch the company's third product "it was career suicide for a venture capitalist to throw money into our industry," says Anderson.

AISI was able to convince a development fund to enter into a nontraditional financing technique that could foster growth without handicapping a company's ability to retain earnings and without diluting its ownership. The fund made an investment that entitles it to a portion of a company's revenue stream. Over time, those slices of revenue-royalties-allowed the fund to recoup its investment. There were three components of AISI's royalty financing:

The Investment

The fund provided a $700,000 investment in thirds, after AISI met certain preset conditions. To obtain the first $233,333, AISI had to turn the prototype product into a preproduction model that demonstrably worked. The second sum would be collected when AISI began production, and the final disbursement arrived when the company began shipping the new product. At every stage, AISI had to account for all its expenditures and was subject to audits by the fund. Although the fund didn't have a seat on AISI's board, Anderson found it easiest to include fund management in board and other company meetings. In all, the investment period took about six months.

Paying Royalties

AISI arranged to pay the fund for the life of the product. AISI paid the royalty-of about 5 percent-on a quarterly basis. The fund had negotiated its royalty on the basis of a number of factors. Key among them: the 25 percent rate of return that the fund required, the expected five-year life span of the product, and the sales projections for the product- more than $30 million over that five-year period. AISI would, of course, pay the royalty beyond the five-year period if the product's sales continued. In case AISI needed to extricate itself from the arrangement, Anderson also negotiated an exit clause. AISI could buy out the fund at any time for $1 million.

The Conversion

As time passed sales related to the new product grew much faster than overall sales at the company, and it was foreseeable that this would continue beyond its five-year life span. With this outlook, it became apparent that the royalty payout would be significantly greater than expected. AISI desired to stop the royalty payments, but didn't have the $1 million to buy out the fund. Instead of borrowing the money to pay off the fund, Anderson elected to pay with equity in AISI-an option that a more possessive business owner might have eschewed. Using the valuation of AISI's stock during the company's most recent round of equity financing, Anderson translated the $1 million into a 10 percent stake for the fund.

There were two key ingredients that made royalty financing workable for AISI. The first was the timing of the repayment. It is rare that the people you owe money to will wait until you have it in hand. However, it is not necessarily the best solution, unless you have the second ingredient: pricing flexibility. A royalty is going to erode your profit margin unless you are able to raise the price you charge for your product by at least as much as the royalty fee.

Fund management points out that this kind of structure can make some difficult-to-finance companies, such as service operations or medium growth businesses, more attractive to investors. Further, royalty financing does not require that a company have significant assets as collateral nor does it require enormous sales growth before an investor can achieve a reasonable return.

Royalty financing is essentially the provision of capital in exchange for a percentage of a revenue stream. The actual royalty percentage, the term, and the exit clause are all negotiable. In this case, these are some of the advantages that this structure had over a conventional equity investment or loan:5

No dilution. The ownership of the company remains the same unless you decide you want to create a conversion feature and sell the revenue stream for equity or attach stock warrants to the agreement.

Great timing. Payments to investors are not required until you start making sales.

Intellectual property (IP) royalty financing is a viable alternative for some companies. IP royalty financing is nonrecourse debt financing. A licensor of IP can take the future cash flow expected from a license agreement and receive a cash payment up front, representing the present value of the future cash flows. This allows the owner of the IP to leverage today what the owner expects to get in the future, and thus add another tool for IP exploitation. Often faced with limited options and funds, financing a royalty stream can provide much-needed capital to research institutions, small and mid-cap companies, and individual inventors. This type of financing is not particular to any specific type of IP. It includes patents, copyrights, trademarks, and trade secrets. Unlike other types of financing, IP royalty financing allows the owner of the IP to retain all of the upside in asset value. IP royalty financing is a unique source of capital collateralized by IP royalties. This may be an attractive vehicle for companies with robust royalty streams and a need for capital.6

Royalty Financing for Mining

Funding for advanced exploration, feasibility studies, mine development, and mine site capital improvements or production expansion is often a major problem for many small and midsize mining companies. Traditional methods of financing these projects have been through personal loans from friends and relatives, bank loans, joint ventures, and attempting to take the company public. Often, none of these financing methods are available or suitable for small and midsize miners. Traditional financing methods may not be economically suitable because of drains on capital or operating income or problems associated with losing operating control or sacrificing the owner's equity. Mineral product, lending, and investment market conditions may also prevent miners from relying on typical capital funding methods at times when money is most needed. There are royalty-based financing techniques that mining companies can obtain to fund their operation and growth.

Royalty-based financing for mining is a specialized technical and financial niche in the mining industry that provides custom-tailored methods for mining companies to acquire mine development and production expansion capital. Royalty companies and investment groups can provide the miner with capital for improvement, expansion, or purchase while also providing the necessary return on investment to both the miner and the royalty group. One of the main benefits of royalty-based financing is that a production royalty allows the miner to maintain 100 percent ownership in the mine. For many mining operations, capital funding can be obtained without any payback obligation except the creation of a royalty based only on mineral production and sales.7

Life Science Applications of Royalty Financing

Though we have illustrated some creative concepts, royalty deals are less common outside the biotech industry. Smaller biotech companies that have spent years developing a compound often take royalties in exchange for distribution rights from a larger pharmaceutical partner. In these cases, the royalties can be from 5 to 20 percent, depending on how far the compound has progressed through the regulatory process and how large the market is for the compound. The biotech company typically has no distribution capability and needs royalties as a source of revenue to fund future compound development. As a compound completes various phases of trial review by the Food and Drug Administration (FDA), pharmaceutical distribution interest increases because the compound's market and advantages over existing compounds become more quantifiable.

Royalty deals are generally used when a product has a proven track record or a quantifiable market; there needs to be a concrete way to estimate potential revenue streams. Another common use of royalties occurs where a larger company wants to discontinue distributing a product line and sells it for an up-front fee and royalty.

Usually, royalties are exchanged for rights to intellectual property where inventors or owners do not have the capability to manufacture or distribute a commercial product. Inventors often find themselves with a royalty prepayment and future royalties in exchange for the IP rights. Many of these deals are not very satisfactory because the products often do not get commercialized or do not get the proper marketing support and attention. Priorities and management change inside larger companies, and it is difficult to protect the inventor and ensure the product will be successful.

Micro-Cap Public Entities

The base content of this section is adapted from the articles "Concept IPO's" and "Shell Corporations" provided by www.VCExperts.com. Written permission requested and granted specifically for this publication. All rights reserved, VC Experts, Inc.

In some market cycles, including that of the Internet bubble of the late 1990s, the interest in high-tech issues is so robust that concept or resume initial public offerings (concept IPOs) are feasible. Feeding frenzies in the public market spotlight certain underwriters who are prepared, on a best efforts basis, to agree to promote a public offering of securities in a company that has no sales or earnings-only a concept and/or the impressive resumes of its officers and directors. The prospectus of a concept offering will, to be sure, contain Draconian warnings that the offering is "speculative" and involves a "high degree of risk." In the appropriate market environment, however, those warnings often attract rather than repel investors. There are international variations on the theme. Some auction markets- the British Unlisted and the Vancouver Stock Exchange, for example-admit to trading shares of development stage companies. Despite the occasional success stories, few if any experienced professionals recommend the premature public offering as a desired strategy, since the burdens of public registration are so significant and the risks of failure are magnified in the public arena; there are fewer excuses and little forgiveness for losses and poor performance.

Another occasionally used technique for raising money is to gain control of a small public entity. The concept is to organize a shell corporation-no assets, no business-and take it public. Because of the unfortunate connotations of the term shell in the financial arena, sponsors have developed the alternate label of acquisition company or specified purpose acquisition company (SPAC). The sole purpose of a shell/SPAC offering is to raise a relatively modest amount of money, and more importantly, to get a number of shares outstanding in the hands of the public. Usually the shares are sold in units-for example, one share of common plus warrants at the current offering price. The sponsors of the shell corporation then find an operating company with which to merge. The merged companies then start reporting the results of operations; if and when those results are promising, the existing stockholders exercise their warrants, injecting needed capital into the enterprise. The object of this exercise is to go public first and then find a business operation afterward; in that sense it is like a concept offering. But the concept is pure, unsullied by even a business description except to find companies after the IPO with which to merge; warrants (purportedly, at least) supply an evergreen source of financing at attractive prices for the original investors.

Another method, a variation on the shell strategy, involves the identification of an existing shell or inactive public company (IPC) as a candidate for a reverse acquisition. A typical example is a company recently emerging from bankruptcy, stripped of its assets other than a modest amount of cash, the assets having been disposed of and the creditors paid in a reorganization proceeding usually labeled a liquidating Chapter 11. The principal asset of the IPC (other than the cash, if any) is its public registration (although the shares are not then trading on a national market system) and a roster of shareholders.

Transaction expenses are reportedly lower in a reverse acquisition, even after adding in significant postclosing expenses necessary to acquaint the financial community with the business of the newly public firm. Indeed, in the end, the ownership remaining with the shareholders of the target is not supposed to be dramatically different than if an IPO were successful. The latter, however, is supposed to offer speed, greater certainty of completion, less burdensome filing requirements, and independence from general market conditions. The company's fund-raising effort starts, in fact, after the acquisition closes and the shares are listed. Thus, a bridge loan, a private placement, and/or an offshore offering under Regulation S often accompany the acquisition.

In the case of both SPACs and IPCs, a certain amount of heightened SEC scrutiny can be expected, especially as the impact of Sarbanes-Oxley is vetted.

Lastly, there are cases whereby a very small publicly traded company exists with solid financial fundamentals, a respectable balance sheet, reasonable earnings and cash flow, and some level of routine trading. However, the company needs new products, services, or technologies to grow. A merger or acquisition by one of these companies with a privately held growth company seeking capital sometimes makes a compelling story and provides an opportunity to meet both companies' needs.

1 This example is from the article "Royalty Financing" in Entrepreneur magazine, June 14, 2002. http://www.entrepreneur.com/article/0,4621,300801,00.html.